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Buying an investment trust on a discount versus a premium

Buying on a discount can be profitable

This mini-series has previously explained what investment trust discounts and premiums are and why they arise. Click through to read those articles if you’ve not done so already.

The obviously crucial thing we need to consider when buying a trust on either a discount or premium to its net assets is the impact on our wealth.

Remember, when you buy shares in an investment trust, you’re theoretically the owner of a portion of the trust’s net assets, as indicated by your share of ownership in the company.

Of course, you can’t demand the trust is liquidated to get at your assets (unless you own enough shares to influence the board!) In practical terms, your shares are only worth what someone else will pay for them when you resell them on the market – whatever the underlying NAV might be.

As a result, any movement in the discount or premium while you hold the shares will affect the return on your investment.

NAV growth and the share price

Provided the discount or premium remains unchanged during your ownership of the shares, the share price will capture the full impact of any increase or decrease in the underlying assets.

People get confused about this, so here’s a quick example:

Let’s say you buy Monevator Investment shares at a 25% discount to the £1.60 NAV.

i.e. You pay £1.20 a share.

The simply brilliant manager [ahem] makes great stock picks, and the NAV doubles from £1.60 to £3.20.

Despite this great performance, the discount remains unchanged at 25%.

So your shares are trading at £2.40 (i.e. 75% of £3.20) against the NAV of £3.20.

The key point is that you’ve made the same 100% return in the share price as the NAV has doubled, despite the persisting – but constant – discount.

How a narrowing discount increases your return

What’s more likely to happen in the above scenario is that the performance of the manager who has doubled the trust’s net asset value will be noticed by other investors, and they will want a piece of the action.

This would mean more people wanting to buy the shares, leading to the discount being reduced (narrowing) as demand for the trust hots up:

Let’s say it narrowed from 25% to just 5%.

At a 5% discount to the £3.20 NAV, the shares would be trading at £3.04.

In this case, the doubling of the NAV plus the closing of the discount has boosted the return on your initial purchase price of £1.20 a share.

In fact, you’ve made a 153% return!

Premiums can reduce your returns

A discount narrowing from 25% to just 5% is an unusually good outcome, unless you’re lucky enough to purchase shares in the trust when the market is going through one of its fits.

But the general point should be clear – it’s great to buy an investment trust at 25% less than the value of its assets and then to see that markdown shrink due to good performance. You get a double whammy of a return.

Of course, the converse is true when you buy a trust at a premium to its underlying assets.

If you buy an investment trust on a premium and that premium to NAV closes – either because the share price doesn’t keep up with the NAV growth, or because the NAV doesn’t grow or shrinks and the share price falls even faster – then it will reduce your return versus the performance of the trust’s underlying portfolio.

For this reason, I almost never buy trusts on a premium.

One of my favourite investment trusts, RIT Capital Partners, frequently trades at a premium to its NAV, thanks to its great track record and investors taking optimistic views on the value of its illiquid holdings. I don’t sell my RIT holding just because of the premium – I’d just have to buy back in later. But I have only ever bought the shares when they were priced at or below net asset value.

This is a cautious approach, and it will mean you will sometimes miss out on an excellent performance from a trust that’s become popular with investors.

Better safe than sorry is my view, but you’ll have to make your own mind up.

Cut-price trusts boost your income, too

There’s a particular advantage for income seekers buying investment trusts priced at less than their NAV.

You will get a superior dividend income from a trust on a discount, because the trust will pay out the same income stream from its net assets regardless. Since you’ll have bought more exposure to those underlying assets for the same money, you’ll get more income.

  • A 10% discount to NAV will boost your income from that trust by 10%, compared to if the share price was the same as the NAV.

There’s not many free lunches in investing, but buying a good equity income investment trust on a big discount may be one of them! For this very reason, income-focused trusts usually trade close to their net asset value.

Beware: A really big discount or one that is out of whack with other trusts in its sector can be a warning sign. Investors may rightly fear something is amiss with the trust (or know that it is!) and so require a big markdown to assets before buying in to help protect their downside.

Look closely at such an investment trust’s gearing (debt), the sort of assets it holds, and its management’s plans and track record. If in doubt, avoid.

{ 4 comments… add one }
  • 1 Gabriela September 10, 2010, 12:56 pm

    ‘There’s not many free lunches in investing, but buying a good equity income investment trust on a big discount may be one of them! ‘

    And that’s the hard part, I’d say, recognizing whether you’re getting a free lunch, or you’re being that sucker at the poker table 🙂
    .-= Gabriela on: Visual Guide to ETFs =-.

  • 2 ermine September 10, 2010, 3:30 pm

    another welcome IT post, but are you sure about the header
    “Buying on an investment trust…” – the title says “Buying an investment trust…”

    One of the things I don’t get about ITs is how to evaluate the gearing component. If I’m a widget maker and I borrow from the bank for plant to make widgets I can see how to get a feel for that, but gearing in an IT puzzles the heck out of me.

    I’m hoping for an October storm for “the market is going through one of its fits.” sort of action…
    .-= ermine on: saving electricity at home =-.

  • 3 The Investor September 10, 2010, 5:07 pm

    @Gabriela – Well, as I recounted in this article there’s more than half a dozen investment trusts in the UK with multiple decade histories of paying a rising dividend income. No guarantees of course that anything in investing will continue, but there have certainly been times in that period where you could pick some of these trusts up for 10%+ discounts or more (such as the recent period linked to in the article). If you’re investing for income and so intend to hold and ignore any capital fluctuations, that’s a great time to buy.

  • 4 The Investor September 10, 2010, 5:10 pm

    @Ermine – Oops, you’re quite right, thanks for that! I’ve fixed it, though the error will live on for posterity in the ropey URL slug.

    Re: Gearing, I’ll pencil in a future article! It’s a very good point to raise, particularly in the context of income-focused trusts.

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